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Equity markets are under considerable strain as there are no indications that Trump will reverse course on tariffs. The search for safe-haven assets in the currency market is leading investors to liquid currencies with significant current account surpluses, most notably the Japanese yen and the Swiss franc. The US dollar’s vulnerability stems from its 4% GDP current account deficit, unless a financial crisis ensues.
Reports suggest President Trump remains firm on reshaping global trade. Asian equities have fallen, and this global trade conflict is leveling global interest rates, causing convergence downwards. The Federal Reserve is central, with markets anticipating 110bp of cuts this year and a low easing point of 3.00% next year. Chair Powell noted the tariffs’ impact would be “significantly larger than expected.”
Despite Powell’s acknowledgement of tariff-induced inflation, the market is fixated on stock market and growth prospects, anticipating Fed cuts. Declining long-term inflation expectations in the USD 5Y5Y inflation swap are likely fueling this view, as US and global growth forecasts are being broadly reduced.
Defensive positioning is favored in FX markets amidst equity market turmoil. Liquidity is crucial, as is a balanced balance of payments, ensuring a country’s independence from foreign capital. The dollar is negatively impacted by its 4% current account deficit and concerns that foreign investors will withdraw capital or increase FX hedge ratios. While there’s no clear “sell America” sentiment, increased US 5-year sovereign Credit Default Swaps and upcoming Treasury auctions present negative dollar event risks.
Concerns linger that this political crisis could escalate into a financial one. Widening US high yield credit spreads raise the risk of uncovering hidden financial problems. The EUR/USD three-month cross-currency basis swap should be closely monitored; any widening favoring the USD could signal trouble and briefly boost the dollar before Fed intervention.
The JPY and CHF are expected to be favored, while EM currencies and commodity FX will likely suffer. The dollar’s performance will fall somewhere in between.
The week’s focus will be on US CPI and PPI data, gauging the impact of tariffs. The market might interpret higher inflation as dollar-negative due to its effect on real consumption. Other events include the NFIB small business optimism report and FOMC minutes.
The DXY index is heavily influenced by Europe, which is a trade war loser. The yen’s weight is only 14%. Overall, the dollar remains fragile, and the 102-103 range might break down to 100 if the Fed eases or a “sell America” mentality develops. The USD funding situation is a wildcard.
